A lot has happened to Chipotle since I last wrote on the stock back in October of last year. As is well known, Chipotle faced a number of health-related issues that forced the closure of numerous stores. Many restaurants have faced similar outbreaks in the past, but those restaurants did not have consecutive strings of outbreaks, nor did it happen during a time when social media allowed news to spread quickly. As a result, sales dropped off a cliff and the stock has declined by 45% since the initial reports. For those who hold very strong beliefs on the future of a company, the outbreaks serve as a stark reminder that the future for any company is never certain.
Today, the bulls and bears paint very different pictures on Chipotle stock. The key debate revolves around Chipotle's future growth - is Chipotle a maturing company with a health issue that sped up that maturation process (and then some), or is it a company facing several temporary headwinds, but will eventually win back its loyal customers and get back to its prior state?
The Bull Case - Chipotle Will Get Most of its Customers Back and Restore Profitability
The bull case centers around sales and profitability recovering back to prior levels (or close to it). Prior to the health issues, Chipotle was a strong brand with extremely loyal customers. While the health issues have made customers hesitant to go back to Chipotle, time heals all wounds. There are several data points that suggest this will occur.
1) Health scares are a common event in the food industry. Many other restaurants have faced similar health outbreaks, and many have recovered to prior volume levels within a year (i.e. Wendy's in 2006, Jimmy John's in 2013, and Taco Bell multiple times over the last decade).
2) Chiptopia, Chipotle's recently-launched customer loyalty program launched in the beginning of July, has seen some success in getting customers back into stores. This is Chipotle's first major customer loyalty program, which should help get customers into stores and visiting more frequently. While some have noted the complexity of the program confusing customers, it has seen promising initial results. The company recently noted on its 2Q conference call that 30% of all transactions were participating in the program, and that traffic had improved to negative mid teens in July (compared to -20% traffic for all of 2Q and in June). Additionally, 28% of Chiptopia customers have already visited the restaurant at least twice (in the three weeks it has been launched).
3) Customers are gradually coming back to Chipotle. At least one survey from William Blair has noted that customer perception of Chipotle's brand is gradually improving. William Blair's survey also noted that Chiptopia was succeeding in driving increased traffic to stores, primarily from the company's most loyal customers. This is further supported by the data points that the company has given us. We know that comps in 2Q began in the -26% range, and improved down to -23.6% for the quarter. Management noted that trends were currently running -20% to -21% in July, suggesting that the overall trend continues to improve. Note that investor expectations for 3Q is for comps of roughly -18%.
4) Chipotle is also doing a number of other things to get customers back into the restaurant. First, the company is launching chorizo, which is expected to be in all stores by the end of the year (note that the company normally does not make many changes to its menu). Early results have shown that chorizo represents 6-7% of sales in test stores. Second, Chipotle has invested more heavily in marketing and promotion. Management expects these initiatives to give customers a reason to go back to a store and slowly regain trust in the brand.
The bullish scenario suggests 25%+ upside. If the company is able to get back to ~90% of prior peak restaurant sales and a restaurant profitability level of 22% by 2018 (compared to prior peak of 27%), the company could achieve $15.50 in EPS (which is close to consensus numbers). Using a 30x multiple (taking into account potentially more modest EPS growth going forward and historical ranges of 25x - 50x), CMG could get back to a price of $465. Higher sales or margin levels would generate higher EPS and could get the stock price up to the $500s or higher (25% upside from its current price).
The Bear Case - Many Question Marks Still, Including the Sales Recovery
The bear case against Chipotle is that the company was already facing slowing sales and earnings growth as the restaurant was approaching maturity and peak penetration within the U.S. Health issues sped up that maturation process, and the recovery could now be both slower and smaller. Factors to support this argument:
1) Customers coming back to Chipotle is not as inevitable as it might seem. The competitive landscape is different now. Many Chipotle-like food service companies have popped up, and customers now have more options for high-quality fast food. When customers stopped going to Chipotle during the peak of their health issues, many went on to try out some of those options, and may not be coming back to Chipotle. So even if Chiptopia is successful in getting the loyal customer back, Chipotle still faces the issue of getting less loyal customers back into stores.
2) Profitability is another issue. With loyalty programs and Chipotle running free burrito promotions, some fear that customers are being trained to look for promotions before going to Chipotle. Even if the company is able to get to prior sales levels, or close to it, how severely will profitability be impacted? The company has already stated that profitability will be several hundred basis points lower due to new health procedures put in place. Layering in higher levels of promotions and a potentially lower sales base, many investors believe that Chipotle will not get higher than the low 20's in margin.
3) 2Q results had some positives, but overall showed that the company has yet to see the recovery that many expected. Look back at the CMG comps chart in the bull section. While the recovery has slowly improved, the rate of improvement has been fairly slow. Bears see this as evidence that the recovery will not get back to prior levels.
4) The company may begin to slow store growth, which could depress the multiple. The company currently projects 12-13% unit growth, but with the health issues and a slowing top line, some investors believe it would be more prudent to slow unit growth. This would not only lower sales growth, but it would also lower the multiple that the company earns from investors.
Bears see further downside of 25%+ if sales continue to remain sluggish. With the company reaching 85% of prior peak restaurant sales and 20% profitability by 2018, the company would achieve ~$12 in EPS. In that scenario, with doubts over the competitive landscape and a potentially lower unit growth outlook, the company would likely generate a lower multiple of 25x (the bottom end of its 5 year range), which would suggest a stock price of $300 (25% downside from its current price).
Key Issue is the Sales Recovery
Ultimately, the key issue for Chipotle revolves around the degree of the sales recovery. Results so far have been sluggish, and as a result, investors have lacked conviction in the direction of the company. The company will need to show more material signs of business improvement in order to bounce off its stock lows.